Scottish-born economist - Angus Deaton - recently published his new book - An Immigrant Economist…
This is Part 3 in Deficits 101, which is a series I am writing to help explain why we should not fear deficits. In this blog we consider the impacts on fiscal deficits on the banking system to dispel the recurring myths that deficits increase the borrowing requirements of government and that they drive interest rates up. The two arguments are related. The important conclusions are: (a) deficits introduce dynamics which put downward pressure on interest rates; and (b) debt issuance by government does not “finance” its spending. Rather debt is issued to support monetary policy which is expressed as the desire by the RBA to maintain a target interest rate.
In Deficits 101 Part 1 I provided a diagram which depicted the vertical relationship between the government and non-government sectors whereby net financial assets enter and exit the economy. What are these vertical transactions between the government and non-government sectors and what is the importance of them for understanding how the economy works? Here is another related diagram (taken from my latest book Full Employment Abandoned: Shifting sands and policy failures) to help connect the pieces. You might like to click on the picture to get it into a new window and then print it while you read the rest of the text.
Vertical and horizontal monetary relations
You will see that this diagram adds more detail to the original diagram from Part 1 which showed the essential relationship between the government and non-government sectors arranged in a vertical fashion.
Focusing on the vertical train first, you will see that the tax liability lies at the bottom of the vertical, exogenous, component of the currency. The consolidated government sector (the Treasury and RBA) is at the top of the vertical chain because it is the sole issuer of currency. The middle section of the graph is occupied by the private (non-government) sector. It exchanges goods and services for the currency units of the state, pays taxes, and accumulates the residual (which is in an accounting sense the federal deficit spending) in the form of cash in circulation, reserves (bank balances held by the commercial banks at the RBA) or government (Treasury) bonds or securities (deposits; offered by the RBA).
The currency units used for the payment of taxes are consumed (destroyed) in the process of payment. Given the national government can issue paper currency units or accounting information at the RBA at will, tax payments do not provide the state with any additional capacity (reflux) to spend.
The two arms of government (treasury and central bank) have an impact on the stock of accumulated financial assets in the non-government sector and the composition of the assets. The government deficit (treasury operation) determines the cumulative stock of financial assets in the private sector. Central bank decisions then determine the composition of this stock in terms of notes and coins (cash), bank reserves (clearing balances) and government bonds.
The diagram above shows how the cumulative stock is held in what we term the Non-government Tin Shed which stores fiat currency stocks, bank reserves and government bonds. I invented this Tin Shed analogy to disabuse the public of the notion that somewhere down in Canberra was a storage area where the national government was putting all those surpluses away for later use – which was the main claim of the previous federal regime. There is actually no storage because when a surplus is run, the purchasing power is destroyed forever. However, the non-government sector certainly does have a Tin Shed within the banking system and elsewhere.
Any payment flows from the Government sector to the Non-government sector that do not finance the taxation liabilities remain in the Non-government sector as cash, reserves or bonds. So we can understand any storage of financial assets in the Tin Shed as being the reflection of the cumulative fiscal deficits.
Taxes are at the bottom of the exogenous vertical chain and go to rubbish, which emphasises that they do not finance anything. While taxes reduce balances in private sector bank accounts, the Government doesn’t actually get anything – the reductions are accounted for but go nowhere. Thus the concept of a fiat-issuing Government saving in its own currency is of no relevance. Governments may use its net spending to purchase stored assets (spending the surpluses for instance on gold or as in Australia on private sector financial assets stored as the Future Fund) but that is not the same as saying when governments run surpluses (taxes in excess of spending) the funds are stored and can be spent in the future. This concept is erroneous. Finally, payments for bond sales are also accounted for as a drain on liquidity but then also scrapped.
The private credit markets represent relationships (depicted by horizontal arrows) and house the leveraging of credit activity by commercial banks, business firms, and households (including foreigners), which many economists in the Post Keynesian tradition consider to be endogenous circuits of money. The crucial distinction is that the horizontal transactions do not create net financial assets – all assets created are matched by a liability of equivalent magnitude so all transactions net to zero. The implications of this are dealt with soon when we consider the impacts of net government spending on liquidity and the role of bond issuance.
The other important point is that private leveraging activity, which nets to zero, are not an operative part of the Tin Shed stores of currency, reserves or government bonds. The commercial banks do not need reserves to generate credit, contrary to the popular representation in standard textbooks.
The central bank operations aim to manage the liquidity in the banking system such that short-term interest rates match the official targets which define the current monetary policy stance. In achieving this aim the central bank may: (a) Intervene into the interbank money market (for example, the Federal funds market in the US) to manage the daily supply of and demand for funds; (b) buy certain financial assets at discounted rates from commercial banks; and (c) impose penal lending rates on banks who require urgent funds, In practice, most of the liquidity management is achieved through (a). That being said, central bank operations function to offset operating factors in the system by altering the composition of reserves, cash, and securities, and do not alter net financial assets of the non- government sectors.
Money markets are where commercial banks (and other intermediaries) trade short-term financial instruments between themselves in order to meet reserve requirements or otherwise gain funds for commercial purposes. In terms of the diagram all these transactions are horizontal and net to zero.
Commercial banks maintain accounts with the central bank which permit reserves to be managed and also the clearing system to operate smoothly. In addition to setting a lending rate (discount rate), the central bank also sets a support rate which is paid on commercial bank reserves held by the central bank. Many countries (such as Australia, Canada and zones such as the European Monetary Union) maintain a default return on surplus reserve accounts (for example, the Reserve Bank of Australia pays a default return equal to 25 basis points less than the overnight rate on surplus Exchange Settlement accounts). Other countries like Japan do not offer a return on reserves which means persistent excess liquidity will drive the short-term interest rate to zero (as in Japan until mid 2006) unless the government sells bonds (or raises taxes). This support rate becomes the interest-rate floor for the economy.
The short-run or operational target interest rate, which represents the current monetary policy stance, is set by the central bank between the discount and support rate. This effectively creates a corridor or a spread within which the short-term interest rates can fluctuate with liquidity variability. It is this spread that the central bank manages in its daily operations.
In most nations, commercial banks by law have to maintain positive reserve balances at the central bank, accumulated over some specified period. At the end of each day commercial banks have to appraise the status of their reserve accounts. Those that are in deficit can borrow the required funds from the central bank at the discount rate. Alternatively banks with excess reserves are faced with earning the support rate which is below the current market rate of interest on overnight funds if they do nothing. Clearly it is profitable for banks with excess funds to lend to banks with deficits at market rates. Competition between banks with excess reserves for custom puts downward pressure on the short-term interest rate (overnight funds rate) and depending on the state of overall liquidity may drive the interbank rate down below the operational target interest rate. When the system is in surplus overall this competition would drive the rate down to the support rate.
The demand for short-term funds in the money market is a negative function of the interbank interest rate since at a higher rate less banks are willing to borrow some of their expected shortages from other banks, compared to risk that at the end of the day they will have to borrow money from the central bank to cover any mistaken expectations of their reserve position.
The main instrument of this liquidity management is through open market operations, that is, buying and selling government debt. When the competitive pressures in the overnight funds market drives the interbank rate below the desired target rate, the central bank drains liquidity by selling government debt. This open market intervention therefore will result in a higher value for the overnight rate. Importantly, we characterise the debt-issuance as a monetary policy operation designed to provide interest-rate maintenance. So government debt serves a monetary policy function as part of the central bank’s desire to maintain specific interest rate targets.
The significant point for this discussion which we build on next is to expose the myth of crowding out is that net government spending (deficits) which is not taken into account by the central bank in its liquidity decision, will manifest as excess reserves (cash supplies) in the clearing balances (bank reserves) of the commercial banks at the central bank. We call this a system-wide surplus. In these circumstances, the commercial banks will be faced with earning the lower support rate return on surplus reserve funds if they do not seek profitable trades with other banks, who may be deficient of reserve funds. The ensuing competition to offload the excess reserves puts downward pressure on the overnight rate. However, because these are horizontal transactions and necessarily net to zero, the interbank trading cannot clear the system-wide surplus. Accordingly, if the central bank desires to maintain the current target overnight rate, then it must drain this surplus liquidity by selling government debt, a vertical transaction.
The myth of crowding out
We now know that it is a myth to perpetuate the idea that a currency-issuing government is financially constrained. This myth underpins arguments by orthodox economists against government activism in macroeconomic policy. There is another persistent myth that needs to be dispelled – that government expenditures crowd out private expenditures through their effects on the interest rate.
We have seen that the central bank necessarily administers the risk-free interest rate and is not subject to direct market forces. The orthodox macroeconomic approach argues that persistent deficits reduce national savings … [and require] … higher real interest rates and lower levels of investment spending. Think back to the 7.30 Report transcript I provided a couple of days ago.
Unfortunately, proponents of this logic which automatically links fiscal deficits to increasing debt issuance and hence rising interest rates fail to understand how interest rates are set and the role that debt issuance plays in the economy. Clearly, the central bank can choose to set and leave the interest rate at 0 per cent, regardless, should that be favourable to the longer maturity investment rates.
While we have seen that the funds that government spends do not come from anywhere and taxes collected do not go anywhere, there are substantial liquidity impacts from net government positions as discussed. If the funds that purchase the bonds come from government spending as the accounting dictates, then any notion that government spending rations finite savings that could be used for private investment is a nonsense. A financial expert in the US, Tom Nugent sums it up like this:
One can also see that the fears of rising interest rates in the face of rising fiscal deficits make little sense when all of the impact of government deficit spending is taken into account, since the supply of treasury securities offered by the federal government is always equal to the newly created funds. The net effect is always a wash, and the interest rate is always that which the Fed votes on. Note that in Japan, with the highest public debt ever recorded, and repeated downgrades, the Japanese government issues treasury bills at .0001%! If deficits really caused high interest rates, Japan would have shut down long ago!
As I have previously explained, only transactions between the federal government and the private sector change the system balance. Government spending and purchases of government securities (treasury bonds) by the central bank add liquidity and taxation and sales of government securities drain liquidity. These transactions influence the cash position of the system on a daily basis and on any one day they can result in a system surplus (deficit) due to the outflow of funds from the official sector being above (below) the funds inflow to the official sector. The system cash position has crucial implications for central bank monetary policy in that it is an important determinant of the use of open market operations (bond purchases and sales) by the central bank.
Here is another diagram that I have drawn to help you put together this part of the argument. You might like to click it to show it in a new window and print it out for reference to make the argument easier to follow.
You can see the individual functions of the arms of government are summarised: (a) The Treasury runs fiscal policy which we summarise as government spending and taxation which on any day has some net impact on the economy – either a surplus (G > T) or a deficit (G < T); and (b) The RBA conducts monetary policy through setting an interest rate target. It also has to manage the system-wide cash balances to keep control of its target rate. It does this by selling/buying government debt to influence the reserve positions of the commercial banks.
To repeat, government debt in this context is used to maintain these bank reserves such that a particular overnight rate can be defended by the central bank. You can see from the diagram that G adds to reserves and T drains them. So on any particular day, if G > T (a fiscal deficit) then reserves are rising overall. Any particular bank might be short of reserves but overall the sum of the bank reserves are in excess. In Australia, overnight reserves earn less than the target rate (whereas in some countries they earn nothing). So it is in the commercial banks interests to try to eliminate any unneeded reserves each night. Surplus banks will try to loan their excess reserves on the Interbank market. Some deficit banks will clearly be interested in these loans to shore up their position and avoid going to the RBA’s discount window which is more expensive.
The upshot, however, is that the competition between the surplus banks to shed their excess reserves drives the short-term interest rate down. But, if you understood the discussion above about horizontal transactions (they all net to zero!) then you will appreciate that the non-government banking system cannot by itself (conducting horizontal transactions between commercial banks – that is, borrowing and lending on the interbank market) eliminate a system-wide excess of reserves that the fiscal deficit created.
What is needed is a vertical transaction – that is, an interaction between the government and non-government sector. In the diagram you will see that bond sales can drain reserves by offering the banks an attractive interest-bearing security (government debt) which it can purchase to eliminate its excess reserves.
That is, the bond sales (debt issuance) allows the RBA to drain any excess reserves in the cash-system and therefore curtail the downward pressure on the interest rate. In doing so it maintains control of monetary policy. Importantly:
- fiscal deficits place downward pressure on interest rates;
- bond sales maintain interest rates at the RBA target rate;
Accordingly, the concept of debt monetisation is a non sequitur. Once the overnight rate target is set the central bank should only trade government securities if liquidity changes are required to support this target. Given the central bank cannot control the reserves then debt monetisation is strictly impossible. Imagine that the central bank traded government securities with the treasury, which then increased government spending. The excess reserves would force the central bank to sell the same amount of government securities to the private market or allow the overnight rate to fall to the support level. This is not monetisation but rather the central bank simply acting as broker in the context of the logic of the interest rate setting monetary policy.
Ultimately, private agents may refuse to hold any further stocks of cash or bonds. With no debt issuance, the interest rates will fall to the central bank support limit (which may be zero). It is then also clear that the private sector at the micro level can only dispense with unwanted cash balances in the absence of government paper by increasing their consumption levels. Given the current tax structure, this reduced desire to net save would generate a private expansion and reduce the deficit, eventually restoring the portfolio balance at higher private employment levels and lower the required fiscal deficit as long as savings desires remain low. Clearly, there would be no desire for the government to expand the economy beyond its real limit. Whether this generates inflation depends on the ability of the economy to expand real output to meet rising nominal demand. That is not compromised by the size of the fiscal deficit.
Here is a summary of the main conclusions of this blog.
- The central bank (RBA) sets the short-term interest rate based on its policy aspirations. Operationally, fiscal deficits put downward pressure on interest rates contrary to the myths that appear in macroeconomic textbooks about crowding out. The central bank can counter this pressure by selling government bonds, which is equivalent to government borrowing from the public.
- The penalty for not borrowing is that the interest rate will fall to the bottom of the corridor prevailing in the country which may be zero if the central bank does not offer a return on reserves, For example, Japan has been able to maintain a zero interest rate policy for years with record fiscal deficits simply by spending more than it borrows. This also illustrates that government spending is independent of borrowing, with the latter best thought of as coming after spending.
- Government debt-issuance in the context of open-market operations is a monetary policy consideration rather than being intrinsic to fiscal policy; and
- A fiscal surplus describes from an accounting perspective what the government had done not what it has received.
In short, we should reject any notion that the emerging federal deficits are damaging and will indebt the future generations. The government has chosen to maintain a positive short-term interest rate and that requires the issuance of debt if there are downward pressures on that rate emerging from the cash system. In the next blog in this series Deficits 101 Part 4 I will argue why short-term interest rates should be kept at or around zero, as they are in Japan and the US at present.